Emerging Markets Set for Review

A potential reshuffle of the global pecking order of nations is at hand this week: one which has nothing to do with football.

Billions of dollars of investment are at stake in China, Korea and Taiwan as the MSCI Emerging Markets Index tracked by global fund managers prepares to come under review after U.S. markets close on Tuesday.

The index provider very rarely tinkers with the index because of the potential effects on the $3.9 trillion of equities it tracks in risky markets from Mexico to Malaysia, and often delays additions to the index or reclassifications if it feels the exchanges don’t deserve them.

This year though, MSCI will decide for the first time whether to add so-called Chinese A shares, mainland-listed stocks denominated in yuan, to its widely-followed benchmark. Meanwhile, Korea and Taiwan are under review for potential upgrade from “emerging” to “developed market” status that would kick them out of the index, but give them the potential to attract more cash from investors who only buy securities from countries deemed safer than emerging markets.

“Upgrades have a big influence into the flow of funds into these countries,” said Mark Austen, chief executive of the Asia Securities Industry and Financial Markets Association (ASIFMA), a trade group. “If you’re added to an index, just by dint of that, money has to flow in.”

Domestic Chinese stocks are largely absent from the index, though MSCI includes equities listed offshore in the U.S. and in Hong Kong, and others denominated in U.S. dollars on China’s exchanges.

China accounts for 18.9% of the index at present, though MSCI argues that it should raise this weighting to 27.7% to reflect the country’s global clout.

MSCI’s plan is to add Chinese shares equivalent to 0.6% of the Emerging Markets Index from May 2015, eventually increasing this to 10.2%.

Deutsche Bank, which sells yuan-denominated China funds, says the move would be “a small step, but an important milestone in opening up China’s equity market.” Some $7 billion of investment would be attracted as a result of the initial change, with inflows rising to $133 billion if MSCI’s plan is fully implemented, the bank says.

But investment quotas and currency convertibility issues make it difficult for many trading firms to access Chinese markets, says Nick Ronalds, managing director for equities at ASIFMA, which represents companies including BlackRock and UBS.

However, a recent move by Hong Kong and Shanghai to connect their stock exchanges will make it easier for global investors to buy Chinese shares, and could be a potential workaround. “If the launch is successful and it continues to evolve, I think we could expect them to join at some point,” Mr Ronalds says.

Deutsche Bank favors a review in six months after the Hong Kong-Shanghai link is scheduled to commence operations.

MSCI tends to ponder decisions carefully: Korea has been under review for six years and Taiwan for five.

“For Korea and Taiwan, net inflows into equities will likely be significant if their status is changed,” says Nomura, with each country poised to attract $11.3 billion and $8.6 billion respectively – though the bank expects the two will fail to meet MSCI’s criteria this time round.

However, there are detriments to an upgrade too – a big weighting in MSCI Emerging Markets can be preferable to a smaller weighting among larger developed markets. Citigroup said some clients reported concerns that an upgrade for Korea could trigger outflows.